Most investment advisors recommend exposure to international stocks with the rationale that they improve portfolio diversification which over the long term is supposed to produce greater returns at lower risk. A 2013 article in the Wall Street Journal surveyed several experts for their recommendations, and the answers ranged widely, from 10% to 50% of an investor’s stock portfolio in international stocks. One expert acknowledged the lack of consensus, responding that the percentage is “more than 0 and less than 100.” This sentiment was echoed by another expert who stated that “no one knows the right amount to hold in foreign investments…we’ll only know the correct amount in retrospect.”A key issue with international stocks, particularly those of developed nations which comprise the majority of international stock market value, is correlation. International stocks are highly correlated to U.S. stocks thereby calling into question the benefit of diversifying into international markets. Furthermore, this correlation has been growing stronger in the last 10-15 years. Over the last 40 years the correlation between U.S. and international markets has been about 0.6 (a 1.0 correlation means the markets move together in perfect unison, while a 0.0 correlation means the two markets have no relationship whatsoever). However, this figure has been steadily rising, from 0.47 in the 1980s, to 0.54 in the 1990s, to above 0.80 in the last 15 years – a level at which there is minimal diversification. The high correlation is partially a result of greater globalization in the last two decades. In fact, 40% of U.S. corporate earnings were derived overseas in 2008, double the 20% level in 1999, as seen in the chart below. This means that by buying a broad basket of U.S. stocks, an investor is already heavily invested abroad, lowering the need for international stocks.

These already high correlations become even stronger in market downturns – precisely when an investor would want a diversified portfolio to provide some protection. In the last market plunge from end of 2007 to early 2009 the correlation between U.S. and international stocks was about 0.92, meaning that international diversification did nothing to protect you from the market decline (a phenomenon called the “contagion effect”). The correlation in the 2000-2002 plunge was also high at 0.83. What about emerging market stocks? Emerging markets include countries such as China, Brazil, India, Mexico, Malaysia and Thailand. Emerging market stocks as a whole have lower correlations to U.S. stocks versus developed nation stocks, but these correlations have also risen significantly. The correlation from 1991-2013 was 0.44, but for the 10 years ending 2013 was much higher at 0.67. Although correlations are lower, emerging market stocks are notoriously volatile and carry significant risks, from political upheavals to the possible collapse of the local currency. The charts below compare the performance of the S&P 500 (in red), developed market stocks (in green, as measured by the MSCI Europe, Australasia and Far East Index), and emerging market stocks (in blue, as measured by the Vanguard Emerging Market Stock Index). The first chart shows performance for about the last 10 years; as can be seen, developed market stocks tracked the S&P 500 from 2005-2011, but lagged in mid-2011 to 2012, resulting in long term underperformance. Emerging market stocks were more volatile, but over this time period outperformed both other indexes.

The second chart shows performance for the last 2 years ended May 2014. Developed market stocks and the S&P 500 have closely tracked each other, but most notably, emerging market stocks have badly lagged since early 2013. Given the long term track record of emerging market stocks, now could be a good opportunity to enter this sector while it appears cheap relative to other markets.

DIA’s conclusions and recommendations regarding international stock are as follows:

International stocks should comprise a portion of an investor’s portfolio allocated to stocks. The recommended percentage varies for each portfolio based on the overall allocation model. In general, DIA typically recommends a 5%-20% allocation for portfolios that have exposure to the stock market. For example, a portfolio recently created by DIA allocated 50% to U.S. stocks, 10% to international stocks, and 40% to various types of fixed income.

The allocation to international stocks is not crucial. The higher correlations in the last decade have reduced the benefits of international stocks in our view, but most analyses do demonstrate a benefit over the long term. In a market crash, it won't matter.

Emerging market stocks may be appropriate for the more aggressive portion of a portfolio, and may be preferable to developed market stocks. With lower correlations and the possibility of outsized gains, a 3%-10% allocation is worth considering. Investors should be prepared for sharp moves in both directions with these stocks.

Invest in international stocks only with Index ETFs. Look for broad market indexes, but also consider a mixture of focused indexes such as single country funds.

Note that this article was written to provide information and education, and is not intended to be considered investment advice, which can only be provided by DIA following a consultation and execution of an Investment Advisory Contract.

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